Commentary: Employers are bad fund-pickers, so switch to an IRA

You might not be much better at it, of course. But before you even select from among the offerings in your 401(k) or other retirement plan, you’re depending on your employer to supply you with good choices.

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According to new findings from the Center for Retirement Research at Boston College, most employers do a pretty bad job at that. The study, done by Edwin Elton, Martin Gruber and Christopher Blake, showed that 401(k) plan administrators choose mutual funds that lag comparable indexes. When changing plan offerings, administrators routinely chase returns and do not improve performance.

In fact, about the best thing the study could say for employers’ fund-picking ability was that the index-lagging funds they chose performed “better than comparable, randomly selected funds.” In plain English, that means that the administrators’ fund-picking ability is marginally better than nothing, barely surpassing the level of a monkey with darts, a random-name generator, and Rusty, the stock-picking steer.

To make matters worse, the inability of administrators to properly select funds is then compounded by plan participants’ tendency to follow investment strategies that add no value, and to chase returns.

In short, it’s “Garbage in, garbage out,” at least if the result you were hoping for was superior investment returns.

That does not mean investors should drop their plans or curtail their retirement savings. Tax rules, employer matching funds and other incentives can make even a bad, costly 401(k) saddled with poor funds into a reasonably effective savings vehicle. Besides, if this is what your employer offers, it may be the only retirement-savings option available to you.

The study’s authors stopped short, however, of drawing what should be the obvious conclusion — the takeaway that applies for any investor with a 401(k). It goes like this: If your employer stinks at picking funds, the minute you no longer are required to be in the plan should be the minute you remove your money.

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That does not mean cashing out, but rather transferring your plan assets into a self-directed individual retirement account (IRA) — a tax-deferred savings plan that you control, where you choose the investment options rather than relying on what a plan administrator offers.

Gruber, a scholar in residence at New York University’s Stern School of Business, says that’s precisely what he did upon leaving past employers, rolling his savings into a self-directed IRA at a low-cost, big-name fund shop.

“You have two issues,” he says. First, are the plan administrators selecting the right funds? “Even if they are, you have to wonder if they are charging you more to own it because of the recordkeeping costs and other expenses that come from being part of the plan,” he says.

If you like the funds you own inside your plan, Gruber says, you will probably like them even more outside of the plan, because you will own them at a lower cost. “Let’s say you are afraid to make a decision — you just want to stick with what you own and know, so you just roll the money directly into the same funds but in a self-directed IRA,” Gruber says. “You’d wind up with a better return from the exact same funds.”

The next question, of course, is whether you could do more than just cut expenses by selecting better funds.

That’s not nearly so sure a thing. The study made it clear that individual investors aren’t necessarily better at picking funds than plan administrators. One key advantage individual investors have, however, is that while plan administrators have to worry about structuring their plan so it’s good for their business — which often leads to increased costs passed to employees — individuals can focus on looking out for themselves.

Statistically speaking, eliminating one layer of potentially poor fund-picking — from the employer — should improve a retirement portfolio’s chances of doing well.

Since the study showed that 401(k) performance typically lags the benchmarks, plans that don’t even offer index choices are probably less than ideal. Armed with that information, investors in such plans should be planning to move their money the moment they leave their job and are able to.

Plenty of workers don’t bother to take control of their retirement assets when they leave or retire, thinking the employer has pros picking the funds, or noting that they used those funds to build up their nest egg. They also worry about making mistakes as they roll the money from their retirement plan into a self-directed IRA, mistakes that could create massive tax liabilities.

The good news is that those concerns are overblown in an era when investors can call virtually any fund firm they like and arrange to do a rollover quickly and easily, with trained representatives there to make sure the funds get transferred without triggering tax woes.

“It’s a simple process to do a rollover,” Gruber says, “and it’s definitely something that pretty much everyone should be looking at as soon as they can.”

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